Reaching the limit
17 May 2004
Many professionals, including law-yers, currently practising thr-ough partnerships assume that conversion to a limited-liability partnership (LLP) under the Limited Liability Partnership Act 2000 will solve all their risk-related problems. Unfortunately, that is not the case.
The liability profile of a member under an LLP is certainly an improvement on the position of a partner under a general partnership. Conversion to LLP status is not, however, a cast-iron security blanket for its members.
With an LLP, a member (as partners are termed in an LLP) acts and contracts as agent for, and on behalf of, the LLP so as to bind the LLP. This contrasts with the situation with a partnership, where a partner acts and contracts as agent on behalf of their fellow partners. However, while the LLP certainly has the primary responsibility for its own obligations, this is not to say that a member avoids all primary and secondary liabilities in respect of these obligations.
Principally, in the area of negligence, a member – like all employees of the LLP – may still be liable to a client for that member’s own negligence where a duty of care is owed. While the member, like the firm, may well be covered by insurance, if the insurance cover is inadequate or falls away for any reason, the member remains personally exposed. The degree of exposure cannot be forecast with certainty, as case law suggests that the courts would have regard to a number of factors in determining whether a duty of care exists.
These include whether the member could be said to have assumed responsibility for the advice and whether the client relied upon such assumption of responsibility in circumstances where such reliance was reasonable.
It is possible to contract out of this risk, provided that the exclusion is reasonable for the purposes of the Unfair Contract Terms Act 1977. While traditionally professional firms have not sought generally to exclude any assumption of a personal duty by employees, or to limit their liability for breach, this has been more common with financial and other corporate institutions. As solicitors’ engagement letters grow longer and more complex, this exclusion is almost bound to become part of the standard terms – although, in some jurisdictions, such an exclusion or limit would be ineffective, as local law or local bar rules prevent such exclusions.
Even a contractual exclusion of, or limitation on, liability for negligence is not necessarily a cure-all, as there will remain cases where solicitors have a potential liability in negligence where the person to whom the duty of care is owed is not a party to the contract. Obvious examples which spring to mind are inheritance and trust cases, where the solicitor is unlikely to have a direct contractual relationship with the beneficiaries, but will often owe a duty of care.
It may be argued that only the member who is personally responsible is left ‘hanging in the wind’ to face the claims, but the other members of the LLP do benefit from the protection given by an LLP. To an extent this is true.
Nevertheless, if an LLP suffers a trading loss, whether in the ordinary course or as a result of a professional negligence claim against the LLP arising out of the acts or omissions of one of its members and exceeding the LLP’s professional indemnity (PI) cover, all members, whether directly responsible or not, will stand to lose out. For instance, all members would:
- Need to refund all drawings previously made on account of anticipated profits which failed to materialise during the year in question.
- Forfeit undistributed profits from previous years – including those which may have been reserved for meeting tax liabilities of that member, even though that member would not be released by the Inland Revenue from the tax liability concerned and would remain obliged to find the requisite funds to meet that tax liability when due from alternative sources.
- Forfeit their capital in the LLP. Where, as is often the case, the capital is borrowed, the individual members would still remain liable to their lenders to repay the borrowed monies and to continue paying interest in the meantime.
Thus, where an LLP is struck down by a professional negligence claim, it is all members, and not just the negligent ones, who suffer. They all lose their immediate livelihoods and are probably faced not only with very significant financial losses (in terms of lost capital and foregone drawings), but financial obligations to repay drawings previously made on account of profits in the relevant year, to meet what are now unreserved tax liabilities and, no doubt, to settle the clamour of their lenders for immediate repayment of loans made to fund their capital contributions to the LLP.
Furthermore, the member may well have provided additional support for the obligations of the LLP, either in the form of guarantees (and, possibly, related security) for the borrowings of the LLP and/or have agreed to subordinate all the member’s own claims against the LLP to claims of the banks lending to the LLP. The effect of subordination would, in practice, be to subordinate the member’s own claims to the claims of all creditors of the LLP who take priority.
This subordination could cover any monies lent by the member to the LLP other than by way of capital injection, claims for reimbursement of expenses and rights to undistributed profits.
Of course, the member left hanging in the wind faces the additional threat of personal bankruptcy in the absence of an enforceable exclusion clause or an effective clause limiting liability.
If the overall capital deficiency is not that great and the LLP retains an otherwise viable business, the members may decide that they need to incur additional financial obligations to recapitalise the LLP so as to enable it to continue in business.
It is because merely converting to an LLP is not a complete solution to the financial risks that the issue of contractual limits on liability will not go away, and it is something that will feature increasingly in engagement letters with clients.
Of course, in extreme cases, where the LLP becomes seriously insolvent, members may well face the strictures of the insolvency regime as applied to LLPs. For instance, a member would be subject to Section 214A of the Insolvency Act 1986, which allows for a liquidator to claw back from the member any withdrawals made by that member from the LLP during the two years prior to the commencement of the liquidation if, broadly, the member knew, or ought to have concluded that, after making such withdrawals, there was no reasonable prospect of the LLP avoiding an insolvent liquidation.
A member will also have a personal liability for the LLP’s obligations if (i) there has been wrongful or fraudulent trading, and (ii) the member knowingly permitted the LLP to engage in that trading, or knew, or ought reasonably to have concluded, that the LLP was becoming insolvent and took no steps to minimise the loss to creditors.
Additionally, a member (rather like a director of a company) faces the risk of being disqualified by a court from being a member of an LLP or a company director where the LLP has become insolvent and the court considers that the conduct of the member is such as to make the member unfit to be involved in a management of another LLP or company.
Even outside the insolvency arena, a member (rather like a director) has a range of statutory duties that do not fall on partners in a partnership. These duties include ensuring that the LLP prepares and publishes accounts showing a true and fair view of the LLP’s position and a duty to ensure that the filings with the Registrar of Companies are accurate and up to date. Penalties for a knowing or wilful breach of these duties range from fines to imprisonment.
All that said, would you prefer to be practising as a partner in an unlimited-liability general partnership, or as a member of an LLP?
Consultant Chris Roberts is the project leader of Allen & Overy’s conversion to Allen & Overy LLP
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